This blog covers financial, political and other topics the author gets the urge to write about. It does not provide personal financial, legal or other advice. Consider consulting a personal professional adviser before making any decisions. Copyright (c) 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017 by Leonard W. Wang. All rights reserved.

In general, a bank might use an off-balance vehicle called a conduit or a SIV (or structured investment vehicle) to purchase its loans and securitize them. The bank frequently provides the conduit or SIV a standby line of credit or other credit facility, that allows the conduit or SIV to issue commercial paper. The funds from the commercial paper are used to buy loans from the bank, which are then pooled into asset-backed securities (such as mortgage-backed securities). The conduit or SIV, in essence, becomes a source of funding for the bank. These vehicles are typically not consolidated on the bank's financial statements and are not regulated as if they were part of the bank. They are, in essence, a shadow banking system, that operates in tandem with the regulated banking system. However, the standby credit facilities that the bank provides, if drawn down by the conduit or SIV, can make the conduit's or SIV's problems part of the bank's problems. So the conduit or SIV can have an impact on the regulated banking system.

The business model for these off-balance sheet entities contains the potential for a serious bank management mistake. The commercial paper that funds the conduit or SIV is short term money. The mortgage-backed securities and other asset-backed investments that the conduit or SIV invest in are longer term. Problems arise if the conduit or SIV can't roll over its commercial paper. It would lose the continuing funding for its longer term investments, and would have to liquidate them, if possible, in order to pay the maturing commercial paper.

Today, mortgage-backed securities have largely become toxic, as have many other asset-backed securities. A lot of money market investors don't want to buy the commercial paper offered by conduits and SIVs because of their heavy exposure to these toxic assets. And the conduits and SIVs would have difficulty selling their toxic assets. So they might have to default on their commercial paper--but for the standby credit facilities provided by the banks that set them up.

If the conduit or SIV draws on the credit facility, the toxic assets effectively belong to the bank. The risks the bank sought to avoid by using off-balance sheet vehicles end up on the bank's balance sheet anyway, and losses from those risks may reduce earnings. Banks that presented themselves to the world as well-capitalized and as prudent allocators of their assets may turn out to have been more reckless and less solid than one might have thought. The soundness of their management's strategies could be called into question. Borrowing short to invest long is a time-honored mistake by bankers. They did it in the 1980s, and got burned. Okay, conduits and SIVs are essentially unregulated, but why would the absence of federal banking examiners make a risky strategy any less risky?

To make things more interesting, recall the yield curve inversion of recent years. One wonders how the banks could have effectively used conduits and SIVs with the yield curve inverted for so long. As bond market aficionados know, a yield curve inversion means that intermediate term interest rates have often been lower than short term interest rates. This is anomalous because one would expect to pay a higher rate to borrow for ten years than two years. But such was often not the case.

With the conduits and SIVs borrowing at short term rates, and investing in longer term maturities, they could have found themselves running a negative cash flow if they invested in the more conservative debt instruments. Did they climb up the risk ladder in order to make their borrow short, invest long strategy appear to be profitable? Did they remember that the higher up the risk ladder you climb, the harder the fall if the market fails to continue rising indefinitely? Do the banks' managements have any good explanation for allowing the conduits and SIVs to pursue a borrow short term, invest longer term strategy while the yield curve was inverted?

A couple of Australian banks and a Singaporean bank have apparently been forced to provide assistance to conduits they sponsored. Rumors of conduit problems have swirled around Citigroup.

The efficacy of the regulators' oversight could also be called into question. Were the conduits and SIVs just accounting sleights-of-hand that allowed banks to take off-book risks that were effectively on their books? How was the apparent enthusiastic use of conduits and SIVs, backed by standby credit facilities provided by their sponsoring banks, compatible with the maintenance of the safety and soundness of the banking system? The regulators should be familiar with risks of borrowing short term and lending long term. Did they question the use of conduits and SIVs? Did they consider the wisdom of the basic business model of these entities in light of the inversion of the yield curve? As the debt markets proceed with their decline, a multitude of risks taken in the shadow banking system may see the light of day.

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